In the 36 years I have been on this mortal plane, I can’t remember ever thinking I was, as the kids say (or said in the 1990s) hip. In full candor, the only time your fearless editor uses the word is when I explain to my sprightly wife that my hip hurts because it’s going to rain, and I’ve been sitting on the lawn chair on my porch too long, yelling at the whippersnappers to get of my lawn.
Nonetheless, Briefly Taxing is all about staying at the forefront of tax issues, and so this old codger decided to write an article for you folks, who might just be a little hipper than I am. (Is hipper even a word?) Today, we look at the tax implications of acquiring and selling/exchanging cryptocurrency.
Let me add, that the proposals on the taxation of cryptocurrency change exceedingly often. Why? Because Congress hasn’t quite figured out the buttons on its TV remote, much less how to deal with money you can’t stuff into a physical wallet.
What is Cryptocurrency and Blockchain?
As old and fusty as I feel, I am downright avant-garde compared to the IRS, whose computer system (no joke) is straight out of the Kennedy administration.[1] So, imagine the consternation of the young techie (who likely rolled into the 2014 meeting on his Segway), that was tasked with explaining cryptocurrency to the IRS’s tech team (most of whom were likely well past puberty before Sputnik was launched).
The techie, we’ll call him Skylar, must have had the patience of a saint. Skylar explained that cryptocurrency is not tangible; instead, it is a digital representation of value that functions as a medium of exchange and a store of value rather than a physical token of U.S. or foreign currency (like a buffalo nickel or a Guatemalan quetzal). Some types of cryptocurrency are convertible, which means that they have an equivalent value in real currency or act as a substitute for real currency. It is a digital, encrypted, and decentralized payment system.
Instead of needing financial institutions to coordinate, monitor, and verify each transaction, cryptocurrency’s transactions are verified by “cryptographic proof.” Cryptography, derived from the Greek kryptos (hidden) and graphein (to write), is not new. Secure, coded communications have been used for millennia by the Egyptians, Greeks, and Romans. Modern cryptography identifies and secures the transactions (known as “blocks”) and digitally links and records the blocks on a “blockchain,” which in simple terms is like a global digital ledger that automatically balances, verifies, and regulates itself. Critics of cryptocurrency note that this self-regulation is rather like the fox guarding the henhouse, but many investors seem at peace with the arrangement.
The IRS has adopted a very broad definition of virtual currency (a genus of which cryptocurrency is a species)—quite like that of Supreme Court Justice Potter Stewart, when he said of certain obscenity, “I know it when I see it.”[2] The IRS, viewing cryptocurrency rather disdainfully like pornography, stated that “regardless of the label applied, if a particular asset has the characteristics of virtual currency, it will be treated as virtual currency for Federal income tax purposes.” So, what about the taxation of cryptocurrency?
The Heifer Equivalency
We have learned that cryptocurrency has inherent value, and this value rises and fall with the market.
So does a heifer, and so does her value.
Cryptocurrency can be traded or exchanged.
So can a heifer.
Cryptocurrency is not physical currency like a buffalo nickel.
Neither is a heifer, though somewhat closer, I suppose…
The IRS will “know it when it sees it.”
So, too, can the IRS “know” a heifer by “seeing it.”
So, is cryptocurrency a heifer or a half-dollar? To the IRS, it turns out, cryptocurrency is more like a cow than cash.
Cryptocurrency, a Digital Heifer
Understandably, you cannot (to my knowledge) buy a Bentley with a herd of Holsteins as you can with Bitcoin,[3] but the IRS came out with their position on the tax treatment of cryptocurrency in 2014; so, here we are. For income tax purposes, the IRS will treat cryptocurrency as property, and general tax principles that apply to general property transactions apply to transactions using cryptocurrency.
By way of example, if Skylar works at a hipster tech startup, and his CEO (“Chief Encouragement Officer”) offers to pay his salary in cryptocurrency, he will receive property in exchange for services, which is taxable as ordinary income to him (as regular, cash wages would be). When Skylar sells or exchanges the cryptocurrency or buys something with it, he must recognize any capital gain or loss on the transaction, subject to any limitations on the deductibility of capital losses.
Nota Bene: Because cryptocurrency is treated as property, there are valuable tax planning tools available for businesses, especially closely-held ones, due to the application of the property-for-services rules under IRC § 83. Because cryptocurrency can be thought of as equivalent to stock (for income tax purposes), timing, vesting, and valuation planning should be at the forefront of Skylar’s CEO’s mind when using cryptocurrency as a salary substitute.
I get irritated when the boy-child messes with the thermostat. I can only imagine how pleased I would be if he started a cryptocurrency mining operation out of his bedroom. We would definitely charge a higher rent.
Two points about property after 2017—the Tax Cuts and Jobs Act suspended the ability for most casualty losses (outside of disaster zones). Further, it limited like-kind exchanges to real property. As such, if cryptocurrency is stolen, or you lose access because you misplaced your password (and, consequently, lose access to $220 million), you cannot claim a theft or casualty loss. Furthermore, like-kind exchange treatment does not apply to cryptocurrency.
Mining Cryptocurrency
One can acquire cryptocurrency by “mining,” which is like auditing the blockchain through very sophisticated computing. To put this mining in perspective, the energy used worldwide to mine cryptocurrency is equivalent to the energy consumption of the entire country of Australia. Obtaining cryptocurrency through mining is a taxable event, requiring you to report the income on your return. Gain or loss will be calculated using the value of the cryptocurrency at the time it was mined (i.e., the cryptocurrency’s “cost basis”).
Thus, if the value of the cryptocurrency is higher at the time of sale than mining, then Skylar will have a capital gain. If less, then he will have a capital loss. If mining becomes a legitimate business, deductions for ordinary and necessary business expenses (like electricity) may be available.
Records are Key
Cryptocurrency investors often acquire more coins over time. If you do not identify specific units of cryptocurrency, the units are deemed to have been sold, exchanged, or otherwise disposed of in chronological order, beginning with the earliest unit of the cryptocurrency you purchased or acquired; that is, on a first in, first out (FIFO) basis (as opposed to a highest-in-first-out (HIFO) basis).
Bitcoin hit a high in 2015 of $333; in 2021 it rose to $63,000. Thus, the potential capital gains swing between a bitcoin bought in 2015 and in 2020 that is sold in 2021 could be massive. Beyond the order of sale, records are necessary to prove if the gains are short term capital gains (held for less than a year, subject to tax at ordinary rates of up to 37%) or long-term capital gains (held for over a year, subject to tax at long-term capital gains rate of up to 20%). This is why keeping records of buying and selling is so critical.
According to the IRS, appropriate cryptocurrency records must show-
- the date and time each unit was acquired,
- your basis and the fair market value of each unit at the time it was acquired,
- the date and time each unit was sold, exchanged, or otherwise disposed of, and
- the fair market value of each unit when sold, exchanged, or disposed of, and the amount of money or the value of property received for each unit.
The 10,000 Foot View
Cryptocurrency is more like a cow than cash, meaning that virtual “currencies” are taxed like property, not currency. Holding bitcoin is like holding shares of Apple stock for income tax purposes. Because the IRS treats cryptocurrency as property, you must report capital gain or loss when you use or exchange it—even if you buy something using cryptocurrency as tender. Some cows are depreciable.[4]
Finally, adequate record keeping is critical, even though these records will be harder to come by than if you were selling the Apple stock like the investors of yesteryears, who received paper copies of Forms 1099 from Steve Jobs himself, which the investors picked up in the post office, which was up a hill, in the snow, seven miles from the end of their driveway, which was, itself, two miles long.
And please, do not be a cautionary tale like the German tech entrepreneur Stefan Thomas. Write your password down on a sticky note, put it in Tupperware, bury it in your yard, draw a treasure map, and put the map in your safe. I mean, the man lost over $200 million, all because he wanted to get creative with his password, instead of doing what the rest of us do—use some memorable combination of a favorite pet or less favorite first-born, a birthday, and if absolutely required, a symbol – just one.
After this article, I feel like an old dog with a new trick. I can discuss cryptocurrency with the whippersnappers as I usher them off my lawn.
Now, to figure out how to use “fleek” in a sentence…
Footnotes:
[1] The Individual Master File (IMF), which is comprised of taxpayer data from a massive 1 billion taxpayer accounts, and which is the very backbone of the IRS’s entire infrastructure is, by the IRS’s own admission “antiquated, with an architecture and design that dates back to the 1960s.” Thus, the IRS is using software designed by programmers who, in all likelihood, are dead now. The software could be someone’s grandparent (or great-great-grandparent in a Teen Mom scenario).
[2] Jacobellis v. Ohio, 378 U.S. 184, 197 (1964) (Stewart, J. concurring) (stating that “I shall not today attempt further to define the kinds of material I understand to be embraced within that shorthand description [of pornography]; and perhaps I could never succeed in intelligibly doing so. But I know it when I see it”).
[3] For a brief period from March to early May 2021, Tesla was also accepting Bitcoin, but the company’s mercurial founder changed course without warning, sending Bitcoin stock plummeting 20%.
[4] Just checking if you were still tuned in…and, no, I am not making this up.
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